Above the Crowd

The Revolutionary Business of Multiplayer Gaming

October 19, 2004:

It’s so easy when you know the rules
It’s so easy all you have to do
Is fall in love, play the game
-Queen, Play the Game

What’s the most valuable Internet company in China? Is it a portal? Is it an e-commerce site? No. The most valuable Internet company in China, clicking in at US$2.0B in market cap, is an MMPORG. MMPORG, an acronym whose length is matched only by PCMCIA, stands for Massively MultiPlayer Online Role-playing Game (a shorter acronym, MMOG is also gaining acceptance). Simply speaking, MMOGs enable multiple players from multiple geographies to meet online and interact in some form of digital group activity. Once considered a niche business, and even a failed one in the U.S., the prospects for multi-player gaming businesses are rising sharply. This renewed faith may be prescient, as the business case for MMOGs is remarkably compelling.

Today’s MMOGs are direct descendants of Multi-User Dungeons (“MUDs”); text-based multiplayer adventures popular with the UNIX crowd in the early 1990’s. Since then, there have been numerous failed attempts at MMOGs , including several companies such as Worlds, Inc. that achieved a high profile status during the orginal Internet boom. The first title to obtain undisputed business success was Ultima Online, originally released in 1997 by Electronic Arts’ Origin Studios. In a telling move, the creator of Ultima Online, Richard Garriott (aka “Lord British”), is now working with Korea’s NCSoft, as MMOG’s have found their largest audiences in the Asian markets.

NCSoft’s hit MMOG, Lineage, has amassed more than four million users, and NCSoft has gone on to deliver many successful follow-ups, including Lineage II and more recently City of Heroes, which they are marketing primarily in the US. Like China’s Shanda, NCSoft sports an impressive market capitalization of US$1.7 billion. Webzen, the number two player in Korea, sports a US$780 million capitalization, while NetEase, a portal in China that generates over 50% of revenue from gaming, has a market cap of US$1.3B. Make no mistake about it — these are real businesses.

Shanda, despite being considered by some a “Johnny-come-lately” and by others a mere distributor, is the undisputed champion of the Chinese MMOG market. The company, which began by repackaging a massively multiplayer game from the Korean developer Actoz, is a distribution machine. It was early to deploy its provisioning technology and promotional materials to nearly all of China’s several hundred thousand Internet cafes. This allowed the Internet cafes to collect cash on behalf of Shanda, a critical accomplishment in a market that lacks credit card adoption. Shanda is now investing in original intellectual property and will be more publisher than distributor in the future.

Despite a price point that can be as much as ten times lower than that in Korea, Shanda’s 2005 forecasted revenues of US$160 million will come close to matching those of NCSoft. This is because Shanda’s average number of concurrent users (700K+) is greater than the number of members that have ever played the corresponding leading title in the U.S. If this were not enough, roll in the low cost of Chinese development, and operating margins come in north of forty percent.

Despite Asian dominance, there are U.S. success stories as well. The leading U.S. MMOG is Sony’s EverQuest, which has attracted around 500K registered users. Concurrent users are likely 10-20% of this number, perhaps 50 to 100K; still dramatically lower than that of Shanda. With a $50 initial fee and a $13 monthly subscription fee, EverQuest is likely in the $80-90 million dollar per year revenue range. A recent Forbes article notes that,”Sony figures it could earn up to $500 million in profits in eight years on EverQuest, which costs $30 million to build and $14 million a year to update.” Nice.

With numerous, innovative MMOGs in the market, the genre has moved beyond its swords and sorcery fantasy beginnings. Players can replicate WWII as a grunt in Battlefield 1942, join in an intergalactic struggle in Planetside, decorate their virtual homes and entertain friends in Sims Online, or build comic book characters and battle evil in City of Heroes. MMOG players make astonishing emotional commitments to their in-game characters and to the master narrative of the virtual world. It’s not uncommon for users to continue paying monthly service fees long after they stop playing regularly, so that they don’t have to “kill” digital avatars in which they have invested literally hundreds of hours of activity.

In fact, in many MMOGs, the opportunity to “make a living” playing the game is totally feasible, and there are many examples of gamers earning north of $40K a year selling virtual property from within the game world. In Korea, some of these passionate activities have taken on a more serious tone, as the government has responded to numerous reports of digital theft. To be clear, this is where one player “steals” a digital asset from another user inside the game world, and the police intervene to try and reciprocate what they view as an abduction of value. Even more seriously, some Korean players have resorted to real-world physical retaliation for battles they may have lost within the game.

Over time, as millions and millions of people from across the globe interact across the Internet, today’s role-playing games will become one of many genres of MMOGs. Already there are examples of MMOGs that are more casual and that penetrate more demographics than today’s titles. In Korea, the leading chat site SayClub has morphed into a multi-player avatar-driven gaming destination. China’s leading instant messenger company TenCent has added gaming to its QQ client and is rapidly becoming a leader in casual multi-player gaming. AOL and Yahoo are quickly mimicking their Asian counterparts. NeoPets, an Internet site focused primarily on children, may in fact be the most successful MMOG in the U.S. While many hard-core gamers may not consider NeoPets a true MMOG, a closer look will reveal many of the core elements, such as avatars, persistence, intellectual growth, group activities, and a virtual economy.

Perhaps the most ambitious MMOG to date is LindenLab’s SecondLife. SecondLife, which most closely resembles Neal Stephenson’s famed Metaverse, from the pages of cyberpunk best-seller SnowCrash, is based on the theory that the MMOG itself should relegate to the users as much creative freedom as possible. In other words, let the community design and build as much of the environment as it can, simultaneously unlocking human potential and business economies of scale. LindenLab has also established an interesting new pricing model where users pay for such things as “land” and “taxes,” and where the community creates actual digital businesses, such as a virtual nightclub that charges admission to an event.

There are many reasons why MMOGs make enviable businesses:

1. Recurring Revenues. Anyone who has ever sold software covets the predictability of recurring revenues, particularly subscription revenues that are basically “good until cancel.” Most of the leading MMOG businesses employ some form of subscription pricing.

2. Competitive Moats. Warren Buffet is fond of saying he likes businesses with castle-like moats (i.e., ones with high barriers to entry). As users invest more and more time into a persistent character, into an avatar, into accomplishments, into online relationships, and into the resulting reputation, the higher the costs to switch to an alternate platform.

3. Network Effects / Increasing Returns. There is no better online barrier to entry than a strong community. Witness how Amazon and Yahoo both failed to distract eBay users even when offering a free product. For most MMOGs, the more users a particular game has, the more compelling the experience is for incremental users. This self-reinforcing form of Metcalfe’s Law is alive and well in many MMOGs.

4. Real Competition. In the future, traditional software-based games will merely be practice vehicles for the much more interesting endeavor of multiplayer competition. MMOGs allow for a sense of competitive accomplishment and provide vehicles for the human ego to be rewarded, all of which drives extremely obsessive behavior.

5. Time Engaged. According to the previously mentioned Forbes article, “a good PC-based game has a lifespan of 30 hours of play; a good multiplayer game gets 20 hours in just a week.” This puts MMOGs, from the perspective of today’s users, on par with television in terms of time engaged.

6. Unlimited Complexity. In a world where other players are part of the user experience, the number of permutations of experiences is quite realistically limitless. From the relatively simple rule-sets and economies present in most MMOGs, astonishingly complex emergent behaviors arise. This offers a stark contrast to previous interactive entertainment where the game can eventually be “beaten” by the user.

7. High Risk, But High Reward. The number one criticism of MMOGs is that they are “hit” businesses like Hollywood businesses. A closer look will reveal that the average successful MMOG has had a useful life of over five years. What’s more, sequels are amazingly popular. As such, it is not unrealistic for a title to last ten years. That said, there are many, many MMOG efforts that fail to reach the break-even number of subscribers necessary to have a positive return on investment. As with the entire history of finance, risk and reward remain correlated.

In the future, one interesting characteristic to watch is just how susceptible a particular title is to increasing returns. As we mentioned, most MMOGs are partial to increasing returns, but there are different levels of scale. Many MMOGs reach an upper limit to their network effect. For example, consider online chess or backgammon. A room of 200 players does not offer a dramatically different experience than a room of two million. For a four-player game like Hearts, that number may by 400 or 500. Add a competition or ladder scheme to the mix and even for simple games, the network effect can rise higher and higher. Complex fantasy games like Lineage or Shanda’s Mir have an even higher liquidity threshold, although they are sometimes limited by their own architecture (only so many players can interact on a particular server instance). The ultimate MMOG will have a viral, self-reinforcing value proposition and no upper limit on its ability to exploit network effects.

Some skeptics argue that MMOG is still a “niche” business and that the same half-million users are migrating from Everquest to Ultima Online to City of Heroes. Under this theory, MMOGs will never be mass market and will never really “matter” in the $20 billion interactive entertainment business. However, with billion dollar businesses now dotting the NASDAQ, it becomes harder and harder to invoke such skepticism. And if new paradigms, architectures, and broadband speeds allow for titles that meet the needs of a wider demographic, ignoring MMOGs may be equivalent to ignoring the successor to television.

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